Business owners are always thinking about the future of their businesses, but how often does that thinking include succession planning? The facts are that more than half of small to mid-size private companies do not have a succession or exit strategy in place. Many believe that succession is merely turning over the company to a family member or eventually finding a third-party buyer, but increasingly there is another popular option that’s frequently overlooked or little understood – selling the company to its employees.
Advantages of an employee stock ownership plan
An employee stock ownership plan (ESOP) can be an ideal and flexible exit-strategy option for business owners. Depending on how the plan is structured, an ESOP can provide a variety of benefits that enables business owners to:
• defer and eventually eliminate capital gains taxes on the sale;
• reduce or eliminate taxes at the company level post-closing;
• create a retirement benefit for employees;
• maintain business continuity; and
• maintain operational control post-sale.
What is an ESOP?
An ESOP is a qualified retirement plan for the benefit of the company’s employees. Rather than holding mutual funds, as is common in a 401(k) plan, an ESOP primarily invests in the employer’s stock. The ESOP rules are set forth in the Internal Revenue Code, and they provide two significant tax benefits:
• The owner may sell his/her shares to an ESOP and either defer or eliminate the capital gains tax on the sale, thereby increasing the seller’s net proceeds by approximately one-third when compared to any other type of sale. For instance, if an owner could sell the company for $20 million to a competitor, he or she would net approximately $15 million after capital gains taxes. With a sale to an ESOP, the owner could net $20 million, or a $5 million increase.
• Since an ESOP is a retirement plan, all of the company’s post-ESOP earnings may be federal and state income tax free, significantly increasing the company’s cash flow. For instance, a company with $3 million in taxable income would pay about 33% in federal and state income tax, or $1 million. With an ESOP, the income tax can be $0, for a savings of $1 million per year.
There are also personal benefits when selling a company to its employees. ESOPs are an especially attractive option for business owners who want their businesses to remain intact beyond succession while also rewarding loyal employees.
Take, for example, Arborwell, Inc., an accredited TCIA member company based in Hayward, California. In 2017, Peter Sortwell, the founder, announced he was transitioning his company to employee ownership. Arborwell had grown from a small residential operation into one of the most recognized commercial tree care providers on the West Coast. Sortwell’s employees had been instrumental in helping drive the company over the years while also cultivating a culture of safety and professionalism. To Sortwell, the ESOP was “a natural step, consistent with (Arborwell’s) recognition of the contributions of each employee in the success of the company, and (Sortwell’s) desire to share the rewards of that success.”
For Arborwell and Sortwell, the ESOP not only fulfilled personal financial goals, but it secured existing employees’ roles while providing them with an opportunity to participate in the future success of the business.
Structuring an ESOP
Any time you sell your business, there’s no guarantee of the outcome. You can, however, follow some guidelines to set yourself and your company up for success by developing and following a solid structure. An ESOP can be structured to best meet the needs of the selling shareholders as well as current and future employees.
The complexity of a sale to an ESOP can vary by factors such as the number of owners or entities involved in the company, the availability of reliable financial information and the ultimate goals of the selling shareholders.
Is an ESOP a good choice for me?
It is essential to assemble the right team of advisors from the beginning who will help you choose the best path to achieve your personal and financial goals. Selling to an ESOP involves several professionals who have different areas of expertise to address issues that may arise during the process. Pre-planning and having a qualified team in place to help guide you in choosing the right exit strategy for both you and your business can save significant time, money and headaches down the road.
Bandit Industries, Inc., a long-time TCIA Corporate Member company based in Remus, Michigan, chose the ESOP path after abandoning two previous attempts to sell the company – once to another manufacturer and once to a private equity firm. “We realized neither was a good fit for Bandit, so we made the decision to sell to our trusted employees,” says Dianne Morey, one of the company’s owners.
For Bandit, the ESOP ensured the corporate culture that had made Bandit a success for 35 years would remain intact. Co-owner Jerry Morey explains, “We have a very strong, dedicated dealer organization and a great crew, which is the key to our success. Our employees are experienced, smart and loyal to us, which is why we were so confident that an employee-owned company would be the right fit for Bandit. All of our employees will have a stake in the company.”
Succession and exit plans are highly customized solutions. There isn’t a template you can use for every business. However, experienced investment-banking advisors will help you reach your goals by structuring and implementing the best succession-planning strategy for your company. An ESOP transaction may be the right solution for business owners who desire to create a smooth transition, retain a life of relevance, preserve their legacies and reward their employees.
Ned Gerhold is a director with Lazear Capital Partners, a TCIA Corporate Member company based in Columbus, Ohio.